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How to lose $46 billion

It prides itself on building “amazing products at honest prices”. Yet it seems Xiaomi Corp does not believe that same credo applies to the valuation investors should accept for its initial public offering.

The smartphone manufacturer is in the final stage of a Hong Kong listing. But the deal has been dogged by controversy and negative headlines about Xiaomi’s “inflated” price expectations, its ever-changing IPO structure and even the company’s environmental credentials.

The order book closed on Thursday, and when trading starts on July 9, Xiaomi will rank as Hong Kong’s sixth or seventh largest ever IPO. That is not a bad achievement in anyone’s book. The eight year-old firm’s offering should end up as weighty as state banking giants such as Postal Savings Bank and China Construction Bank, which were respectively valued at $59.2 billion and $71.6 billion when going public in Hong Kong in 2016 and 2005.

The South China Morning Post reported today that Xiaomi will have a market worth of $54 billion – having priced its $4.7 billion IPO at the lower end of its marketed range. (If it is able to exercise the overallotment option, which expands the base deal by 15%, the company will sell 9.99% of its enlarged share capital.)

This is not what Xiaomi and its investment bankers had hoped for: a far higher $100 billion valuation had been earlier flaunted in financial media outlets. Even at a valuation that’s $46 billion lower than that there are still some analysts who think that it’s too much.

The deal should have also been the crowning glory for the Hong Kong Stock Exchange, which is keen to lure China’s tech companies away from New York and the Chinese A-share market. Instead, the whole process has been overshadowed by Xiaomi’s botched plans to become the first company to issue China Depositary Receipts (CDRs) in Shanghai. Its decision to drop the dual-listing plan on June 19 has left the IPO looking badly thought out.

It all feels like a let-down, given the flotation was once as hotly anticipated as Alibaba’s in 2014. Why the excitement? In part because Xiaomi is an example of a Chinese company that successfully adopted a leading global business model – in this case Apple’s – and then produced quality products at reasonable prices for less developed countries.

Xiaomi was the smartphone parvenu and managed to take customers from the likes of Samsung before it started to stumble in 2016 when Chinese rivals like Oppo and Vivo began eating into its market share. But it responded strongly and within one year it was able to rebuild its global sales position and regain fourth place (see WiC408).

First quarter smartphone earnings show that Xiaomi registered 90.6% year-on-year sales growth thanks to its growing popularity in India. During the first quarter, it eclipsed Samsung on the subcontinent, taking a 27% market share.

Xiaomi has also demonstrated that it is not a one-trick pony. It is creating an Apple-like ecosystem and monetising its users through the Internet-of-Things (IoT) and internet services. The former recorded 55% year-on-year revenue growth during the first quarter and the latter 59%.

Indeed, the fast-growing internet services arm helped Xiaomi to achieve a positive net profit margin at the end of 2017: 4.7% compared to minus 0.5% the previous year. Adverts and subscription services on apps like Mi Browser and Mi Music enabled the division to record a 74.8% compound annual growth rate (CAGR) in sales between 2015 and 2017 and a gross margin of 60.7%.

So what is the problem? Perhaps the biggest issue Xiaomi’s IPO has faced is its timing. Had it come earlier this year, it would have caught the tail end of the recent bull market.

Unfortunately, it appears to have come just one month too late. Over the past couple of weeks, Hong Kong’s equity markets have followed China’s lead and entered negative territory for the year.

Until mid-June, Hong Kong was one of the few Asian equity markets still registering positive gains. However, Washington’s decision to impose new tariffs on Chinese goods appears to have changed the mood. As of Thursday’s close, the benchmark Hang Seng Index was down 4% year-to-date.

The recent experience of Ping An Healthcare and Technology is a classic example of what happens to an IPO when a market is on the turn. The $1.12 billion deal, which priced at the end of April, was extremely well received. The retail tranche closed 654 times oversubscribed.

But by the time the online health platform began trading in early May, sentiment was already teetering. By the end of May, the share price had fallen 20% below its offering price and it was still trading under water as this month began.

In better market conditions, it seems highly likely that investors and analysts would have been swept up by market momentum and dazzled by Xiaomi’s IPO just as they were by Tencent-backed China Literature, which listed in Hong Kong last November.

Instead, Xiaomi’s financials have been unpicked and hung out to dry, and the Financial Times reported that investors were underwhelmed by the tech firm’s Hong Kong roadshow presentation. As one analyst told the newspaper: “At the end of the day, Xiaomi is a hardware company that produces iPhone rip-offs while it is pricing itself above Apple on a price-to-earnings (PE) basis.”

Indeed, Xiaomi’s price range assumes a PE of 22.7 to 29.3 times the IPO syndicates’ 2019 earnings’ forecasts. The IPO sponsors initially believed Xiaomi’s fair valuation was between $65 billion to $92 billion. That would have put it at a significant premium to the likes of Apple, which trades around 14 to 15 PE multiples, but at a discount to Chinese internet stocks in general, which average about 27 times.

At issue is whether Xiaomi should be considered a hardware company or an internet one. In one particularly pertinent response to Xiaomi’s CDR application, Chinese regulators reportedly asked the same question. Even Xiaomi’s boss isn’t entirely sure (“The most difficult question for me is answering exactly what Xiaomi does,” Lei told news agency Xinhua in an interview last July).

The most bearish analysts argue that Xiaomi’s desired valuation cannot be justified, given that internet services accounted for just 9% of its 2017 revenues. They also suggest that even though that part of its business is fast-growing, there are question marks over the loyalities of Xiaomi’s user base. Apple has a strong lock on its high-end customers. Will Xiaomi generate the same kind of support from its more price-sensitive users?

Then there is the issue of Xiaomi’s disastrous attempt to become the first company to issue CDRs. No matter how hard it is spun, the decision to drop the CDR component does not reflect well on Xiaomi or the China Securities Regulatory Commission (CSRC).

It should have been pretty obvious that Xiaomi would never have priced its IPO below the regulator-mandated 23 times trailing earnings cap. Unlike Taiwan’s Foxconn Industrial Internet, which recently listed in Shanghai, it probably didn’t feel it needed to curry favour for political reasons. So why was the deal pushed forward in the first place?

China wants to show that its equity markets are maturing and that its most cutting-edge companies want to trade there. Mismanaging how CDRs are executed is not the best way to demonstrate that.

That said, not everyone is unhappy about how the IPO has been handled.

One often overlooked participant is Xiaomi’s cornerstone investor Qualcomm. The American chipmaker’s presence showcases how cross-border cooperation lives on, even as trade tensions between China and the US, particularly in the tech sector, mount. Qualcomm’s investment seems to undercut the narrative of a growing balkanisation of the two countries technology sectors – a sentiment which has been driven largely because of US national security fears over Beijing’s ‘Made in China 2025’ plan.

And then there are the lucky 56 Xiaomi employees who invested in the company when it was set up in 2010. They stand to make millions. Among them is the receptionist who decided to invest her entire wedding dowry in Lei’s firm.

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